The recent slowdown in the Chinese economy has sparked a big debate about its impact on the rest of the world. The slowing of its economy may be good for China, but will it lead to a double dip in the fragile economies of the West? What will happen to commodity prices? These questions underline the importance of China’s rapid economic growth to the rest of the world.

At the outset, it’s best to clear up some myths. As the authors put it, “While China’s share in world trade has increased dramatically in recent decades it is still small compared with the US. The size of China’s GDP at current exchange rates is only one-fifth that of the US and that of its private consumption is only around one-eighth that of the US (IMF, 2009). Moreover, China accounts for only 3% of world imports of consumer goods and for only 4% of world import growth. China could not, therefore, replace the US as a ‘global consumer’ in the short run."

That said, China does have a major impact on commodity prices, its surpluses reinvested in US government paper have helped to keep interest rates low in the US, and its exports are a source of envy to competitors and have kept prices low across the world. Also, its importance is growing rapidly. China’s share in total merchandise trade with India, for example, has increased from 0.1% in 1990 to 11.5% in 2008.

So what impact does Chinese growth have on the rest of the world? The authors find that in the short term a 1 percentage point shock to China’s GDP growth is followed by a cumulative response in other countries’ GDP growth of 0.4 percentage points over five years. Around 60% of the impact of China’s growth seems to be transmitted through trade channels. And in the longer term, “panel regressions based on the last two decades also suggest a positive spillover impact of China’s growth, with a 1 percentage point increase in China’s growth being correlated with an average of 0.5 percentage point increase in the growth of other countries. Moreover, while China’s spillovers initially only mattered for neighbouring countries, the importance of distance has diminished over time."

Financial Innovation, the Discovery of Risk, and the US Credit Crisis By Emine Boz and Enrique G. Mendoza, IMF working paper

This paper points out that financial innovation was a big reason for the crisis and argues that booms and busts are an integral part of financial innovation. That’s because financial innovation underrates risk, because agents start without a sufficiently long time series of data to correctly evaluate the riskiness of the new financial environment. This in turn leads to higher asset prices, which breeds optimism as people feel wealthier and borrow against the inflated value of these assets. This increases leverage in the system. According to the authors then, excess optimism is natural during periods of financial innovation.

What policy measures are therefore called for?

The researchers say that close supervision of financial intermediaries in the early stages of financial innovation is critical. For example, capital requirements can be used to limit overborrowing. But perhaps their most important conclusion is that the proposed tighter regulations imply a shock to financial innovation, which will force agents to “evaluate the riskiness of the new financial environment with subjective beliefs based on imperfect information. Thus, the risk exists that a few years of slow credit growth and poor performance in asset markets can lead to the build-up of pessimistic expectations that will hamper the recovery of financial markets."